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MGT601 - SME Management - Lecture Handout 23

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This lecture deals with the types of collaterals /guarantees/assets and pledge techniques for security.

Guarantees or Collateral You Can Offer

Not many lenders will consider granting you, or anyone else for that matter, a loan without security. The question will come up early in the discussion. What guarantees or collateral can you offer? The terms collateral and security really mean the same thing. They are guarantees you give to lenders by pledging assets, which they can seize and sell off, if you do not payback the loan. . There are other forms of guarantees that can secure a loan, such as an insurance policy to the benefit of the lender, or an understanding by a third party to repay the loan, should default. The point is that, whichever way you turn, you will obtain a satisfaction from a lender only if you have something to offer should you default in your repayment obligations. The most common form of security is a charge (a pledge) on fixed assets, particularly land and property. Most lenders feel that land and property are readily marketable if this means selling them off at a price below their market value. Moreover, land and property are evidenced by the title deeds and, in many countries, the authority’s register these titles and any encumbrance would also be noted when an asset is encumbered, it means another party has a valid claim on it. When an asset is pledged to a lender, it is encumbered and it cannot be pledged a second time to another party unless the two parties agree to share the security.

Other fixed assets can also serve as a security: machinery, equipment, vehicles and suchlike. But it is often impractical for a lender to consider these as security because their market value is often difficult to determine, especially if they are not new. Instruments are sometimes acceptable to the lenders as collateral, particularly if they can be easily realized (sold). These are evidenced by share certificates of the companies listed on the stock exchange, bonds, debentures, treasury bills etc.

You can pledge current assets: stocks of raw materials, finished goods, and commodities for exports, even receivables. The easiest net asset to pledge is cash. This is called cash collateral. Your loan is secured by money! In practice, borrowers resort to this form of security when they have liquidity in another bank, which they do not want to touch. (It may be in another currency or tied up in investments. It may be funds owned by a third party or even by the borrower, but not part of his or her business).

When you approach an institution for short-term credit, it is useful to have a list of assets that you are prepared to pledge as a security for the loan. If these are fixed assets for which you have the land or other property titles, bring copies with you to show the bank. If you have marketable stocks of raw materials or finished products or, better still, internationally quoted stocks of commodities that are not yet sold, bring warehouse receipts or inventory lists with you. If you do not have warehouse receipts, delivered by a third party and attesting to the quantities or values of the commodities stored, you can usually obtain a certificate from an inspection company evidencing the quantity and quality, sometimes even the price or value, of the goods stocked. Your list of receivables is also useful, because your bank may say that it would be willing to discount some of them, purely and simply, rather than lend you money.

Financial institutions rarely lend the full value of the security taken. The reason is plain enough: should they need to sell the security because of default in the payment, the price they obtain may be less than the value of the loan. The amount of cover needed for loans varies from country to country and asset to asset. In some cases you may to pledge assets worth two or more times the amount of the loan.

Typical Collateral

  • Land and buildings: first, second mortgages, debentures on property;
  • Other fixed assets: charges, debentures on machinery, equipment, vehicles;
  • Share certificates in the borrowing company;
  • Guarantees from banks, other institutions, export credit guarantee and insurance schemes, third parties;
  • Cash; Receivables: invoices, bills, promissory notes;
  • Stocks or inventories of finished goods, commodities, warehouse receipts;
  • Raw materials;
  • Investments, marketable securities.

Negotiating Short Term Credit

Negotiating with a lender (who should be ready in principle to grant you a short-term facility) relies more on how well you are prepared than on any particular bargaining skill. A good knowledge of your business and a sound grasp of all the facts and figures on your results, current situation and prospects are the most convincing arguments you can put forward. As already stated, lenders aim to get a good rate of interest on their money at a little risk. They will probably prefer the types of facilities and payment methods that their staffs are most familiar with, and which do not present too much back office effort or time. As their time is precious, lenders will try to obtain fees for services rendered.

Negotiations should benefit both the parties and each must come away feeling satisfied with the outcome. The relationship will perhaps develop into a long-term one, with the bank growing to appreciate and trust you as transactions develop and your business expands. Bankers are also keen to keep good customers. Banks work in a competitive environment and will vie with one another to get business. If your bank likes to deal with you, because it is pleased with they way the transactions are conducted and there is a feeling of mutual satisfaction and loyalty, your negotiation position will be strengthened and concessions will be granted in your favorite in due course. But building up such relationship will take some time. In the beginning you may have to bear higher charges and pay more fees, because you are new to the financing sector and must first demonstrate your worth.
Obtaining the Most Favorable Terms

There are many ways of arranging a credit package, especially as a far as the trade finance is concerned. Always inquire into the cost of the facility offered and compare this cost with those of the alternatives. If you are able to show the bank that it would be cheaper for you to obtain the same result using another method, point this out tactfully but firmly. But know your facts. If, for some instance, the bank’s interest rate is higher than the bank rate your supplier is prepared to accept for trade credit, state it clearly and be prepared to show a letter to that effect.

In foreign trading, it is virtually impossible to avoid the banking system if you are an exporter or an importer. Most payment methods require a third party to hold money or documents in trust until an obligation is satisfied. The credit you obtain from your bank may be used by the bank itself to pay your supplier (e.g. by opening a documentary credit) or to give you an advance until payment is made by the foreign buyer, with the bank reimbursing itself from the proceeds of the export transaction.

Seek the bank’s advice on the different methods of payments and credit facilities available. Don’t stop at the list given in the bank’s brochure or leaflet. Explore all the possibilities, but remember that your banker will be more knowledgeable than you are about the risks, advantages and drawbacks of each system if you are new to the business. Tact and diplomacy are useful; avoid marring relationships that could prove invaluable later on. It is also worth remembering that the financial sector is a close-knit community despite the competition among its members. A banker will ask for and will easily obtain references on a customer from another bank. Getting the most favorable terms is not only the matter of obtaining the lowest interest rate.

Note: fees, commissions and charges vary from bank to bank but the difference is quite significant. In the case of a documentary credit, for instance, the fees are quite high-the issuing bank charges around 0.4% on issuing the documents, around 0.25% is charged by your bank on arrival of the documents, and for each service rendered, the bank will charge a fee importers are strongly advised not to accept payment terms before being sure of the amount of the fees, charges or commission that may prove to be very expensive in the country from which they are buying. You may in this case ask your bank to enquire about the level of such costs in the country from which you are importing. The best terms for yourself must also include what is most convenient for you. Avoid for instance, tying up fixed assets if you know you are going to need them as a security for a medium-to longer term loan in a few months to finance the purchase of the capital goods such as vehicles or machinery.

Checklist for Commission Fees and Charges

  • Appraisal Fee (Or Front-End Fee): Percentage of total facility paid up front, often as a deduction from principal disbursed. Amount varies from one institution to another.
  • Commitment Fee, Interest Rate Per annum on Un-Disbursed Portion of Facility. This is often waived. Rate usually varies from ½% and 1%.
  • Interest on Outstanding Principal, Overdrafts Expressed as a Per Annum Rate. Rate may reflect lender’s assessment of risk. Low rates may be available through incentive schemes for exporters or for development components considered for special economic benefit to the country. (The method of calculation varies from one institution to another. You should make sure this method is thoroughly explained to you. Fro instance, interest may be calculated on day-to-day balances, or on monthly overdraft ceilings, on a 360-day year and so on)
  • Legal Costs and Charges. Expenses incurred in preparing the legal documentation and drawing up charges, debentures. Mortgage fee 1% of the mortgage value, insurance@ 1 % of the sum ensured, stamp duty @ 1% of the value, registration fee 2% of the mortgage value.
  • Revenue Office Fee: Disbursement fees. Amount charged by the lender as a flat fee at each disbursement if there is more than one.
  • Charges for Payment Facilities, Services. Fees and commission charged for opening and confirming L/Cs, collection and other sundry services rendered by the banks.
  • Discount Rates. Percentage taken by the bank for discounting receivables

Finally, always keep in mind the purpose of borrowing. To survive in the business, you have to be competitive, which means in minimizing costs and overheads. If you borrow, it must always be the better alternative to not borrowing, and this can only be so if the terms and conditions are right. If the financial charges and related costs of borrowing are not to your advantage, and risk putting you into a situation where you are no longer competitive as a manufacturer or trader, make this clear to your banker and turn down his offer to credit unless he is prepared to revise his conditions. The banks must always be your partner in competitiveness.

Improving Your Negotiating Position

Obtaining short-term credit from your bank is hardly likely to be a one-off affair. The chances are that, after the success of your initial transactions, your business will grow and you will become a regular customer for credit facilities. How can you then improve your negotiating position?

“Be a good player” is the first and foremost rule. Build up your reputation as someone who always pays on the dot. Be particularly careful to honor interest payments on time. Interest payments are the bank’s revenue and affect its operating results. Banks have to apply stringent credit risk management rules, usually enforced by regulatory bodies for the banking system. If interest is paid late, banks may have to constitute provisions for risky debts and this affects their balance sheets. Late payment will give you a bad mark and you may become branded as a poor payer and a risky debtor, making it harder or more expensive for you to borrow in the future. Being punctual with your interest payments does not mean that you can be late with the payment of the installments on the principal.

They are also important but, because loans to customers are assets on a bank’s balance sheet, they lose their value (through the constitution of provisions) only if the amount due is outstanding for more than two or three months after the schedule repayment date. This means that a bank will not be too worried if you are a week or so late with your payment of the installment on principal. But the golden rule is to let the bank know beforehand. Do not wait until you receive a reminder or a curt telephone call. Explain as early as you can that there may be a delay, owing to late payment, for instance, by a customer. Provide the bank with supporting evidence of the fact that you will be getting the funds in due course (for instance, a written undertaking from your customer or an accepted bill or a promissory note). Your bank may even be able to assist you by discounting receivables to improve your liquidity or advancing your money against warehouse receipts

Book recommended

Entrepreneurship and Small business Management by CL Bansal

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